Investors who have suffered a substantial loss in a stock position have been limited to three options: "sell and take a loss", "hold and hope", or "double down". The "hold and hope" strategy requires that the stock return to your purchase price, which may take a long time if it happens at all.
The "double down" strategy requires that you throw good money after bad in hopes that the stock will perform well. Fortunately, there is a fourth strategy that can help you "repair" your stock by reducing your break-even point without taking any additional risk. This article will explore that strategy and how you can use it to recover from your losses.
Defining The Strategy
The repair strategy is built around an existing losing stock position and is constructed by purchasing one call option and selling two call options for every 100 shares of stock owned. Since the premium obtained from the sale of two call options is enough to cover the cost of the one call options, the result is a "free" option position that lets you break even on your investment much more quickly.
Here is the profit-loss diagram for the strategy:
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How To Use The Repair Strategy
Let's imagine that you bought 500 shares of XYZ at $90 not too long ago, and the stock has since dropped to $50.75 after a bad earnings announcement. You believe that the worst is over for the company and the stock could bounce back over the next year, but $90 seems like an unreasonable target. Consequently, your only interest is breaking even as quickly as possible instead of selling your position at a substantial loss. (For more strategies to get back on track, read What To Do When Your Trade Goes Awry.)
Constructing a repair strategy would involve taking the following positions:
- Purchasing 5 of the 12-month $50 calls. This gives you the right to purchase an additional 500 shares at a cost of $50 per share.
- Writing 10 of the 12-month $70 calls. This means that you could be obligated to sell 1,000 shares at $70 per share.
Now, you are able to break even at $70 per share instead of $90 per share. This is made possible since the value of the $50 calls is now +$20 compared to the -$20 loss on your XYZ stock position. As a result, your net position is now zero. Unfortunately, any move beyond $70 will require you to sell your shares. However, you will still be up the premium you collected from writing the calls and even on your losing stock position earlier than expected.
A Look At Potential Scenarios
So, what does this all mean? Let's take a look at some possible scenarios:
- XYZ's stock stays at $50 per share or drops.
All options expire worthless and you get to keep the premium from the written call options.
- XYZ's stock increases to $60 per share.
The $50 call option is now worth $10 while the two $70 calls expire worthless. Now, you have a spare $10 per share plus the collected premium. Your losses are now lower compared to a -$30 loss if you had not attempted the repair strategy at all.
- XYZ's stock increases to $70 per share.
The $50 call option is now worth $20 while the two $70 calls will take your shares away at $70. Now, you have gained $20 per share on the call options, plus your shares are at $70 per share, which means you have broken even on the position. You no longer own shares in the company, but you can always repurchase shares at the current market price if you believe they are headed higher. Also, you get to keep the premium obtained from the options written previously.
Determining Strike Prices
One of the most important considerations when using the repair strategy is setting a strike price for the options. This price will determine whether the trade is "free" or not as well as influence your break-even point.
The option strategy is then typically constructed by purchasing the at-the-money calls (buying calls with a strike of $30 in the above example) and writing out-of-the-money calls with a strike price above the strike of the purchased calls by half of the stock's loss (writing $35 calls with a strike price of $5 above the $30 calls).
Start with the three-month options and move upwards as necessary to as high as one-year LEAPS. As general rule, the greater the loss accumulated on the stock, the more time will be required to repair it. (Keep reading about LEAPS in Using LEAPS In A Covered Call Write.)
Some stocks may not be possible to repair for "free" and may require a small debit payment in order to establish the position. Other stocks may not be possible to repair if the loss is very substantial - say, greater than 70%.
It may seem great to break even now, but many investors leave unsatisfied when the day comes. So, what about investors who go from greed to fear and back to greed? For example, what if the stock in our earlier example rose to $60 and now you want to keep the stock instead of being obligated to sell once it reaches $70?
Luckily, you can unwind the options position to your advantage in some cases. As long as the stock is trading below your original break-even (in our example, $90), it may be a good idea so long as the prospects of the stock remain strong.
It becomes an even better idea to unwind the position if the volatility in the stock has increased and you decide early in the trade to hold on to the stock. This is a situation in which your options will be priced much more attractively while you are still in a good position with the underlying stock price.
Problems arise, however, once you try to exit the position when the stock is trading at or above your break-even price: it will require you to fork over some cash, since the total value of the options will be negative. The big question becomes whether or not the investor wants to own the stock at these prices.
In our previous example, if the stock is trading at $120 per share, the value of the $50 call will be $70, while the value of the two short calls with strike prices of $70 will be -$100. Consequently, reestablishing a position in the company would cost the same as making an open-market purchase ($120) - that is, the $90 from the sale of the original stock plus an additional $30. Alternatively, the investor can simply close out the option for a $30 debit.
As a result, generally you should only consider unwinding the position if the price remains below your original break-even price and the prospects look good. Otherwise, it is probably easier to just re-establish a position in the stock at the market price.
The repair strategy is a great way to reduce your break-even point without taking on any additional risk by committing additional capital. In fact, the position can be established for "free" in many cases.
The strategy is best used with stocks that have experienced losses from 10% to 50%. Anything more may require an extended time period and low volatility before it can be repaired. The strategy is easiest to initiate in stocks that have high volatility, and the length of time required to complete the repair will depend on the size of the accrued loss on the stock. In most cases, it is best to hold this strategy until expiration, but there are some cases in which investors are better off exiting the position earlier on.